Wednesday, September 17, 2008

Does the AIG Deal Tell Us the Financial System is Insolvent?

Congratulations. We--you, me and all other U.S. taxpayers--now own American International Group, the largest insurance company in America. This came courtesy of the Federal Reserve, which extended AIG an $85 billion emergency CPR-style loan in exchange for 79.9% of its equity. I never wanted to own an insurance company (they're less well-liked than lawyers). But life does take unexpected twists. AIG is not likely to be a profitable investment. While it has apparently sound subsidiaries engaged in ordinary insurance activities, like life, property, auto, etc. coverage, and also manages money and sells investments like annuities, its big boo boo was to dabble in credit default swaps. These puppies guarantee bondholders, often holders of mortgage backed bonds, against default. Not a profitable line of business these days. We, the new owners of AIG, are likely to take some big losses as a result AIG's dalliance with derivatives.

Recent efforts to arrange a private sector loan for AIG provide some disturbing information. News reports indicate that the Fed and the Treasury leaned heavily on a number of major U.S. and foreign banks to provide AIG with a $75 billion loan. But the banks evidently couldn't do the deal. They had every incentive to do the deal, because a collapse of AIG could seriously impair their own viability. But if they couldn't make this loan even if their survival was at stake, one begins to suspect the financial system as a whole may be insolvent. If you tallied up all of the major financial institutions' assets and liabilities (the latter are the tougher question), would you end up with a negative net worth? Such may have been the case in Japan during the 1990s. Japan has paid a heavy price for the reckless lending of its banks, in terms of low growth and diminished prospects. Is the same in store for America? Federal bailouts like the acquisition of AIG can prevent short term financial panic. But they also spread out the pain over a longer period of time to a larger group of people. There is no avoiding the pain. The only question is who will bear it and when. The nationalization of AIG clarifies the answer. If you want a hint, look in the mirror.

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